HOW ETFs WORK
While an ETF is registered with the SEC as an
investment company—either as an open-end fund or a
UIT—it differs from a mutual fund both in how
shares or units are issued and redeemed and in how
they are traded. (See the exhibit at the
end of this article.) Unlike mutual funds and
UITs, ETF shares are created when an institutional
investor (someone who manages money for
institutions and corporate investors such as
retirement plans or endowment trusts) deposits a
block of securities with the ETF. In return for
this deposit, the investor receives a fixed number
of ETF shares, some or all of which it may then
sell on a stock exchange. What’s
in a Name? ETFs are
known by a variety of sometimes quirky
names—Spiders, Diamonds, OPALs, WEBS
(now iShares), Qubes, VIPERs, HOLDRs and
StreetTracks are just a few. The biggest
institutional players in ETFs are State
Street Global Advisors, the Bank of New
York and Barclays Global Investors. The
American Stock Exchange launched the
first ETF in 1993, with Standard and
Poor’s Depository Receipt Trust, called
SPDR 500 or Spiders. Currently there are
90 ETFs listed on the AMEX with nearly
$75 billion under management, not
including HOLDRs. Morgan Stanley
created OPALs—Optimized Portfolios of
Listed Securities—in 1994. Listed on the
Luxembourg Stock Exchange, they
represent Morgan Stanley’s Capital
International (MSCI) indexes and are
marketed primarily to institutional
investors. The SPDR is the most
widely traded and well-known ETF.
Created in 1995, the mid-cap SPDR tracks
the S&P Mid-Cap 400 Index. Diamonds,
which track the Dow Jones Industrial
Average, were added in 1998. NASDAQ
later introduced Qubes, named after its
ticker symbol, QQQ, to track the NASDAQ
100 Index. WEBS (World Equity Benchmark
Shares now called iShares), mirror
foreign equity market indices. HOLDRs, a
new product trading on the AMEX, issues
depository receipts that represent
individual and undivided ownership
interests in the common stock of
companies involved in a specific segment
of a particular industry. In May
2001 Vanguard began offering its
exchange-traded class of shares called
Vanguard Total Stock Market VIPERs. The
only fund to track the Wilshire 5000
Total Market Index, Vanguard expects its
VIPERs to have an annual expense ratio
of 0.15% ($15 per year on a $10,000
investment)—the lowest of any ETF
tracking the broad U.S. stock market.
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institutional investor can get its deposited
securities back by redeeming the same number of
ETF shares it got from the fund. (See
“Creating an ETF” below for more details.)
Individual investors can buy and sell ETF shares
only when they are listed on an exchange. Unlike
an institutional investor, an individual investor
cannot purchase or redeem shares directly from the
ETF as he or she could with a mutual fund.
Creating an ETF
Exchange-traded funds are
generally created in response to
anticipated demand for a fund to track a
particular market index or industry such
as the Nasdaq 100 or the Wilshire 5000.
When this happens, an institutional
investor or large intermediary such as
Barclays Global Investors or State
Street Global Advisors—known as an
authorized participant (AP)—transfers a
portfolio of stock that closely
approximates the specified index to a
fund manager. The manager places the
stock in a trust and issues ETF shares
to the AP. It is free to hold the new
securities or sell them to other
investors. The ETF shares trade
freely between investors on established
stock exchanges (the American Stock
Exchange is a major player in ETFs).
Small investors generally sell their
shares for cash to another investor.
When an institutional investor with
large ETF holdings decides to exit an
ETF, the securities are retired in
block-sized units. The institution gets
shares of the stock or stocks underlying
the ETF plus some cash representing
accumulated dividends. Depending
on the kind of ETF or the index being
tracked there may be minimum
requirements to create the fund. For
example a unit of 50,000 shares is
required to create Diamonds while a
25,000-share unit is required to create
mid-cap SPDRs.
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can buy ETFs on margin (subject to the same rules
that apply to common stocks) at limit prices and
sell them short in a brokerage account. Certain
ETF products are even exempt from the rule that
requires shares to be sold short only on an uptick
in price. None of this holds true for a mutual
fund.
Creation units. Unlike
mutual fund distributors, ETF sponsors do not sell
shares to the public for cash. Instead they
exchange large blocks of ETF shares—called
creation units—for the securities of the companies
that make up the underlying index plus a cash
component representing mostly accumulated
dividends. Some institutional investors or wealthy
individuals may hold the creation units in their
own portfolios. Others, generally broker-dealers,
break up the units and offer the ETF shares on the
exchanges where individual investors can buy them
in their brokerage accounts through a broker or an
online trading account. ETFs are redeemed
in a way that is the opposite of how they are
created. Broker-dealers buy enough ETF shares from
individual investors to make a creation unit
block. They then exchange the block with the ETF
sponsor for a “basket” of securities and a small
amount of cash. Other institutional investors
simply trade back the creation units in their
portfolio to the ETF sponsor for securities and
cash. Sponsors continually create and
redeem creation units based on investor demand and
for arbitrage purposes. An ETF’s value tracks
closely but does not match exactly the value of
the underlying security, so institutional
investors can measure the price of the underlying
securities in the index against the price of the
ETF. If the price of the underlying securities is
higher than the ETF, the institutional investors
will trade a lower priced creation unit back to
the sponsor in exchange for the higher priced
securities. Conversely, if the price of the
underlying securities is lower than the ETF, the
institutional investor will trade the lower priced
securities back to the fund in exchange for a
creation unit. This arbitrage mechanism eliminates
a problem sometimes associated with closed-end
mutual funds—the fund’s trading for more or less
than the value of the underlying portfolio.
THE TAX CONSEQUENCES
As with any
investment, CPAs should consider the tax
consequences of ETFs to individual investors.
Essentially, the tax implications are identical to
those for ordinary stock. If a client sells in
less than one year, any gain will be taxed as
ordinary income. If the client sells at a gain
after a year, he or she will be taxed at lower
capital gains rates. If the fund loses value,
investors can write off the loss against other
capital gains (and up to $3,000 annually of
ordinary income) when they sell. In
taxable accounts, ETFs are more tax efficient than
ordinary mutual funds. Investor sales can force
mutual fund managers to sell stock to meet
redemption requests. This can result in the fund’s
paying a taxable capital gain to shareholders—even
at a time when the overall market is trending
down. In an ETF, nothing in the underlying
portfolio changes when an investor buys or sells
individual shares. Most trading takes place
between shareholders. The fund doesn’t need to
sell stock to meet redemptions so it avoids
realizing a gain on its holdings. During periods
of heavy redemptions, ETFs avoid selling the
underlying stock holdings by transferring
securities to redeeming shareholders, typically
large investors or institutions. Because these
investors are paid “in kind” with stock, not cash,
other shareholders are protected from a taxable
event. However, ETFs can and do make capital gains
distributions. These usually result when the ETF
must buy and sell stocks to adjust for changes in
its underlying benchmark (the index the ETF
tracks). Current shareholders of mutual
funds pay taxes on distributions, while former
shareholders—who may have benefited from the gains
that created the distributions—do not. ETFs, on
the other hand, use a swapping feature to
eliminate embedded capital gains from the
portfolio. Each security the ETF holds has a tax
basis, and the fund distributes the
lowest-cost-basis securities in its portfolio
during the redemption process. The redeeming
investor is responsible for taxes, and the ETF
ends up with a higher-tax-basis portfolio and
fewer capital gains to distribute—reducing capital
gains exposure for investors when the fund must
sell a particular stock during rebalancing.
Whenever an investor redeems a basket of
securities, the fund gives that redeemer the
lowest-cost-basis stock. It doesn’t matter to the
redeemer, which pays taxes based on its individual
cost basis, not the basis of the underlying stock.
TOO GOOD TO BE TRUE?
So what’s the catch?
Is there a downside for investors CPAs should know
about? To begin with, greater tax efficiency
doesn’t necessarily mean 100% tax efficiency. ETFs
still pay out dividends and any gains that arise
from changes in the composition of the indexes
they track—just as open-end mutual funds do. While
some ETFs—such as Qubes—have made few or no
distributions so far, others make distributions
annually. The biggest catch for investors
stems from one of the major attractions of these
funds—that they can be bought and sold so easily
by calling a broker or accessing an online trading
account. An investor who is tempted to buy and
sell often could eliminate any tax or cost
advantages. Unfortunately, statistics suggest ETF
investors are doing just that. While the typical
mutual fund is held three years, the average
holding period for SPDRs in the first five months
of 2001 was just 19 days and for Qubes only 4
days. In addition, share prices can diverge from
the fund’s net asset value and trade at a premium
or a discount—which means a buyer could end up
paying more for shares than they were worth.
Combined with a brokerage commission, this could
negate the lower expenses. In summary ETFs are a
good idea for index investors but, just as with
mutual funds, CPAs should recommend them only as
part of a balanced portfolio and advise clients to
acquire them on a long-term, buy-and-hold basis.
Some investors never should use ETFs: If a
client makes periodic investments or periodically
rebalances his or her portfolio, he or she could
end up being “eaten alive” by commissions. From a
cost perspective the client would be better off
with a mutual fund. If he or she plans to make a
single large investment, assuming a low commission
(on the buy and sell transactions), CPAs may want
to do the math to determine whether the client
would be better off putting that money in an index
mutual fund.
THE BOTTOM LINE
Why are ETFs so hot?
In a nutshell, they are easy to buy, inexpensive
to own and tax efficient. Unlike mutual funds,
they can be bought and sold throughout the day at
real-time prices, sold short and purchased on
margin. They can be bought through any broker,
which means an investor can further control his or
her expenses by using a discount broker. In
advising clients, CPAs should caution them to
beware of steep sales charges. Initial charges and
exit fees typically amount to 2% to 5%. But annual
operating expenses are very low. Compare Qubes
with an expense ratio of .18% to Rydex OTC, a
mutual fund that also seeks to track the Nasdaq
100, at 1.15%, or Vanguard’s Index 500 Trust at
.18% with Barclay’s iShares S&P 500 fund at
.0945%. ETFs can be significantly more tax
efficient than open-end mutual funds because they
aren’t subject to the cash flow fluctuations. This
is helping generate significant investor interest
in this relatively new investment vehicle.
When the mad hatter is running the tea party,
the best CPAs can do is follow the white rabbit
and recommend ETFs where appropriate. But don’t
let the excitement of the moment replace good
judgment. Once CPAs have completed the asset
allocation portion of the financial planning
process, they can help clients select a mix of
ETFs that meet their goals, risk tolerance and
time horizons. Is there an ETF in your
clients’ future? ETFs initially will cut more into
sales of individual securities than mutual funds,
at least on the retail side. Mutual fund buyers
tend to be conservative buy-and-hold investors who
don’t have brokerage accounts. It will take time
for them to become ETF-savvy, whereas those who
actively purchase individual securities will find
it more natural to buy ETFs. But perhaps the most
interesting angle is that ETFs will bring passive
investing to active securities investors. |